Financial Management II
BBA V
Unit_1:Economics of Financial System
By
Durga Prasad Panta
KIC
Concept of Financial System
Financial
Intermedia
ries
Financial
Market
Financial
Instruments
Financial system comprises of financial institutions, markets and
financial instruments for mobilizing resources
Basic Needs Served by Financial System
• Financial system Facilitate resource transfer and mobilizes
savings to the productive sectors thereby contributing to the
economic development
• The financial sector creates value by helping households, firms
and governments to meet these basic needs
• There are three types of basic needs served by the financial
system:
 (i) Payments
 (ii) Resource Transfer
 (iii) Risk Trading
1. Payments:
• One of the major functions of financial system
• Established global networks of payment
system in financial market has made
international trade possible and easy
• Certain financial assets including checking
accounts and negotiable order of withdrawal
accounts serve as medium of payments
1. Payments cont……….
 Payments
networks are the elemental component of any
financial system

The payment system
-- Allows secure transactions between related parties
-- Permits immediate discharge of liabilities
-- Provides a means to store of value
-- Creates records of transactions

There are three types of payments systems
--
Retail
(credit cards, debit cards, checks, cash etc.)
-- Wholesale
(for business to business payments)
-- Institutional
(between major financial intermediaries)
1. Payments cont……….
• Credit cards issued by banks;
New innovation in payment system; e.g.,
electronic payment system is leading towards
simple, safe and cost reducing payment
system
• Involved intermediary institutions facilitating
payments among the trading parties
1. Payments cont……….
• Warehouse banks:
Banks that keeps depositors’ cash in storage
In exchange for a fee they offer security and ease of
payment, accepts deposits of cash, count and
authenticate currency and safe guard
• Clearing houses:
Association of banks to facilitate clearing
Clearing: collection of checks in which checks drawn
on one bank are settled against check drawn on
another bank
2. Resource Transfer:
Households, firms and governments each face a mismatch in time
between cash flows in and cash flows out

Households
-- Need to borrow early in their life cycle to buy housing and then save in mid-life
for retirement

Firms
-- Need to raise capital for projects early in the life-cycle of the firm, but typically
generate a cash surplus as mature companies
-- Need to manage fluctuations in working capital due to seasonality in revenues
and costs

Governments
-- Borrow to fund budget deficits during the low point of business cycles –
helping to stabilize the economy
-- Borrow to create risk-free debt instruments in the economy (Government
bonds, notes and bills)
ideally
2.Resource Transfer cont………
• Saving, lending and investment behavior of
individuals , business firms and government
units makes possible for transfer of resources
• Financial system by providing different
mechanism facilitates the transfer of
resources as it facilitates lending.
• Lending is a form of trade that Give up
purchasing power now in exchange for
purchasing power tomorrow
2. Resource Transfer cont………
• Diversity among the people in need and
possession of purchasing power make it
possible for trade of purchasing power
• Diversity arises among people because of their
saving, lending and borrowing behavior
• Purpose of saving is to allocate purchasing
power throughout the life
2. Resource Transfer cont………
• There areTwo forms of lending
(i)Direct Lending
(ii)Indirect Lending
(i)Direct Lending:
• Lending by ultimate lender to ultimate borrower
• Direct relation between the ultimate lender and
ultimate borrower
• Intermediaries only facilitate the process
2. Resource Transfer cont………
• Various institutions in the financial system by
making following provisions make easier to lend
Information dissemination
• Financial press- news on companies
• Accounting and auditing firms- check books of
the companies
• Market information on transaction- evaluation of
securities prices
• Negotiations or contract writing
• Write a loan contract or trust deed
2. Resource Transfer cont………
• Underwriter negotiates the terms of loan
contract with the issuer and appoints a
trustee to monitor compliance on those terms
• Underwriter buys whole issue and resells to
the public with legal obligation to purchasers
to provide accurate information about the risk
• All these activities greatly reduce cost and risk
on lending
2. Resource Transfer cont………
(ii)Indirect Lending:
• Lending by ultimate lender to financial
intermediary that then re-lends to ultimate
borrower
• No relationship is established between the
ultimate lender and ultimate borrower
• Intermediaries not only facilitate the process
but also are responsible for repayment to the
lenders and recovery from the borrower.
• Advantages of indirect lending
(a) Information advantage:
• Banks can have large information about its clients whom it
lends, which may not be available to the public
(b)Specialization:
• To assess creditworthiness and monitor performance
• Cost reduction by making large loan
• Pooling of small amount to make large loan
• Cost of large loan relatively lower than small loans
(c) Continue relationship:
• Individuals may lend for one or few time but banks lend to the
same borrower more frequently as it is their main business,
thereby build up relationship with the borrower
• This relationship help them to be in win-win situation
(d) Diversification:
• Individual can make only a few investment- no
diversity
• Banks have diversified investments
• Reduction of risk from diversified investments
(e) Liquidity:
• Through pooling large number of people having
diversity in need and possession of money,
continuous liquidity is possible
3. Risk Trading:
• Financial system provides mechanism to
minimize those risks through trading of risk
• Two forms of trade in risk;
i. Insurance
ii. Forward Transaction
I.Insurance
• Sharing of risk of accidents, illness and natural
disaster
• One who do not face a particular risk agree to
share the losses of those who do
• Insurance policy: contracts with an insurance
company (insurer) under which the insured pays
a premium in exchange for coverage of specified
losses
• One pay the insurers a relatively small sum with
certainty; in exchange the insurer pay a large sum
with relatively low possibility of risk of damage
• Types: Property-liability insurance; life insurance,
health insurance;
• Problems:
• Tendency of insured
• Selection risk for insurer: same price for different condition;
assumed to be less but becomes huge
II.Forward Transaction
• Agreement in advance on the terms of trade to be carried out
in the future
• Sharing of price risk
• Future Markets:
•
• Market in standardized contracts for future
delivery of various goods
• Address the problem of difficulty and cost of
finding trading partners
• Role of forward intermediaries
• Example; explain how both the party benefit
by signing a forward contract
Financial System’s Basic Technology
Financial System’s Basic Technology Includes
•
•
•
•
Delegation
Credit Substitution
Pooling
Netting
Delegation
• Rather than doing the things oneself, one can assign
some one else to the work on his behalf
• This is being done mostly to reduce costs and make
the operations more efficient.
• Examples: indirect lending
* Consumer lending through dealers / suppliers
* Lenders delegating to underwriter task of setting up
a loan & documentation
* In forward trx, traders delegate to Futures EX.
Delegation- Reducing costs
• Many costs of a trx. are indivisible eg.
Syndication of loans.
• Delegation allows specialization. The delegate
representing many lenders and lending more
often acquires expertise.
• The delegate can negotiate better terms.
• Revealing information to one delegate would
be more acceptable to the borrower.
Delegation- Fundamental issue
• How the delegate to be trusted?
• Two possible solutions to this are:
1.Bonding: putting up of assets to guarantee
performance
2.Reputation:General estimation in which
someone is held by the public
Credit Substitution
• Replacement of credit of one party to a transaction with the
(superior) credit of a financial institution.
• In many cases delegation combined with credit substitution. eg. A
bank substitutes its own credit for the credit of the borrower:
depositors lend to the bank rather than to the ultimate borrower.
• Credit substitution works because the promise of bank, insurance
company or future exchange is more acceptable than the promise
of the ultimate trading partner. This is due to following two
reasons:
* Reputation of FI
* FI’s resources and capabilities in fulfilling the promise.
Delegation & Credit substitution
• Delegation & credit substitution may not
always go together.
• Underwriters don't guarantee the issues they
float : there is a delegation but not credit
substitution.
• When bank money is used in payment, the
bank substitutes its own credit for the credit
of the buyer: there is credit substitution but
no delegation.
POOLING
• Pooling is combination of assets & liabilities in
ways that reduce risk or improve liquidity.
• Pooling makes the liabilities of an FI (the
promises it makes) safer and more liquid than its
assets (the promises to it). Eg. pooling makes
bank depositors safer and more liquid than
assets.
• One reason pooling works is diversification, other
is netting.
NETTING
• Netting is offset of one trx. against another, to
reduce the number of trx.s that actually need to be
executed.
• Executing a trx. is costly. Netting lowers costs by
offsetting one trx. against another.
• Example: clearing of checks, by netting bank’s
obligations to one another reduces the need for
physical transfer and thereby reduces costs.
Netting
• Netting also creates liquidity eg. Bank can hold
relatively illiquid assets because it can meet
withdrawals out of new deposits, without
having to liquidate the underlying assets. By
netting new deposits and withdrawals, it
reduces the need to buy and sell the
underlying assets.
• Secondary markets work in much the same
way.